Protectionism

UBS Outlook Switzerland

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A new worry: the strong franc gives way to protectionism

The significant weakening of the franc over recent quarters, which we expect to go even further, should result in a franc that is fairly valued. This is a central component in our optimistic economic forecast for the Swiss economy for the current year. But President Trump’s protectionism is calling up black clouds again on the foreign trade horizon.

The Swiss franc was overvalued against the euro for eight years. This slowed the Swiss export sector and put pressure on prices, forcing the Swiss National Bank (SNB) to pursue very loose monetary policy. Our valuation of the franc against the euro is guided by the concept of purchasing power parity (PPP). We currently put fair value for EURCHF at 1.21 (Figure 1).

Figure 1

EURCHF hovering around fair value

EURCHF exchange rate and purchasing power parity

Move away from loose monetary policy anticipated

The SNB is likely to normalize its monetary policy in the coming quarters. There are two reasons for this; First, the franc has already weakened against the euro over the last twelve months, from 1.09 to 1.15 (and occasionally to as far as 1.20). This has led to a major reduction in the franc’s overvaluation. Second, we expect fair value to fall over the coming years. In the not too distant future it’s possible a EURCHF rate of 1.20 will no longer be considered overvalued.

Inflation in Switzerland has tended to be lower than in the Eurozone in recent decades, so fair value of the franc against the euro has declined. We expect Eurozone inflation to remain higher than in Switzerland, so this downward trend should be maintained. The expectation therefore is that fair value will range between 1.10 and 1.20 over the next few years.

Purchasing power parity

Purchasing power parity (PPP) is the exchange rate that compensates for the difference in inflation between the currency zones in question. Inflation influences the exchange rate over the long term whereas risk aversion, for example, has no more than a short-term impact on the financial markets. Thus PPP is a good benchmark for determining the direction of a currency pair over the longer term. In the short term a rate may deviate considerably from PPP, but in the long term it tends to return to fair value. We calculate PPP using producer prices, which reflect the costs of tradable goods.

Franc remains overvalued for the domestic economy

PPP varies considerably for the different parts of the economy. Figure 2 shows PPP in different sectors. PPP for the domestic economy, especially services, is in some instances well above what we show as fair value. This means the franc is still overvalued for these sectors and prospects are likely to remain mixed where, as for example in retail trade close to the border, they are up against foreign competition.

Figure 2

Big differences in purchasing power parity

Purchasing power parity for different sectors of the economy in 2016

Switzerland has an exceptionally competitive export sector, which over the long term sets the exchange rate. In the labor- intensive domestic economy, though, comparable gains in productivity are scarcely possible. This is also because of stiff regulation in many areas (e.g. healthcare and agriculture), which mean there is little price competition within Switzerland. But export and domestic companies both hire from the same labor market and so have to offer similar salaries. The result is prices that are high in the domestic market compared to abroad.

Here too changes are emerging, though. In recent years online trading and shopping tourism have suddenly exposed a traditionally domestic sector like retail to international competition – and to an exchange rate based on the competitiveness of the export sector. Dealing with this is likely to lead to a considerable increase in automation and digitalization in the service sector: self-checkouts in the supermarket constitute no more than a first step.

Foreign investment to combat the strong franc

Fair value for the Swiss franc implies a balanced foreign trade account. But Switzerland has an annual current account surplus equivalent to more than 8% of gross domestic product, which would tend to suggest the franc is actually undervalued. However, key export industries (especially pharma), can to an extent avoid price competition. The currency will only cease to appreciate if the current account surplus is matched by equally large exports of capital.

Up until 2008, private industry invested abroad on a major scale, exporting capital. After the financial crisis, though, it was mainly the SNB that “exported” capital, by intervening in the currency markets. Over the long term Swiss industry will have to once again increase its foreign investments. If not, either the franc will appreciate considerably in the long term or the SNB will have to continue to intervene in the currency market indefinitely.

A new challenge for the Swiss economy

The overvalued Swiss franc was for a long time the prime concern of Swiss companies. But as the currency weakens, another issue is coming into focus. Rising protectionism, especially in the US but in other countries too, has long tended to be neglected. However, the headwinds facing free trade predate Donald Trump's election as US president. For some time, further market integration has been encountering suspicion and some existing achievements of free trade have even been undone.

Protectionism aside, the US tax reform is also making the economic environment more difficult for Swiss companies. As one likely impact of the tax reform both US and foreign companies will increasingly shift production to the US, creating jobs there. The effects of these measures are only likely to be felt in the long term (if at all); the pharma industry, for example, needs time to move production because of regulation and the permits required.

Current impact on the overall economy is marginal

The US is Switzerland’s second-largest trading partner after the EU. In 2017 Switzerland exported goods worth just under CHF 34bn to the US; of this, pharma accounted for the largest share at 53% and electricals and electronics for 14%. So far the current trade dispute with the US has only seen tariffs imposed on steel and aluminum. Exports of these products last year made up 1% of total Swiss exports. The US accounted for an insignificant 1% of these goods. For individual specialist companies these trade restrictions are painful, but at the level of the overall Swiss economy the effects are marginal.

If the US were to extend trade restrictions to other goods, such as EU pharmaceuticals or car imports, the impact for Switzerland would be much greater. Auto suppliers generate revenues of almost CHF 10bn per year in Switzerland, most of which is exported to Germany. Hence the Swiss economy would feel the secondary effects of trade restrictions between the US and the EU.

Protectionism in Switzerland too

It is not just the US that is seeing protectionist tendencies. Switzerland too is far from making full use of its free trade potential. There are, for example, tariff barriers on agricultural products, complex customs arrangements and varying product requirements. The cost of this isolationism falls on the domestic consumer and sectors that have to pay higher prices for goods than would be the case if markets were open1. The tariff restrictions on trade in the agricultural sector, in particular, show one of the difficulties involved in the opening up of markets: negotiations for the free trade agreement with the Mercosur countries (Argentina, Brazil, Paraguay, Uruguay and Venezuela) are encountering difficulties partly due to objections from farmers.

1 Avenir Suisse: Trade rather than domestic protection

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Protectionism

UBS Outlook Switzerland

Economy & Financial Markets

Global Ecomomy

 

  • The world economy remains strong. Economic trends still suggest that growth this year will match that of last year. Some emerging markets are doing better. In developed markets, strong labor markets are slowly lifting wages. Income growth is then spent. Stronger European and US spending has led to stronger Asian exports. About a third of the US tax cuts is likely to be spent on imports, widening the trade deficit. Most of the US trade tariffs (tax increases) are likely to redistribute, rather than reduce, global trade.
  • Inflation rates remain influenced by technical factors. The long-term trend is for a gradual increase in consumer prices. Companies are finding it easier to raise prices. PPI is generally higher than in the recent past. Wage growth in both the US and Europe is consistent with some modest rise in price inflation. Labor costs typically make up about 70% of a developed economy's inflation. Oil price hikes have raised headline CPI, but central banks are unlikely to react unless this pushes up wage inflation.
  • Real policy interest rates, adjusted for CPI, are still negative in the major economies. Policy should gradually tighten this year.

Swiss Economy

  • The recovery in the Swiss economy is likely to continue in the second half of the year. We expect economic growth of 2.4 percent this year, driven primarily by stronger foreign trade and higher capital expenditures.
  • Inflation is likely to remain just below the 1-percent mark. The drivers here are higher oil prices, the depreciation of the Swiss franc and the increasing utilization of the Swiss economy, which also leads to higher prices in the domestic economy.
  • Now, however, there are also indications of some risks. These include the numerous geopolitical and trade policy hot-spots worldwide, the future fiscal policies of the new Italian government and the significant weakening of European economic indicators.

Currencies

EURCHF

  • We are keeping our EURCHF forecasts at 1.17 in three, 1.20 in six and 1.22 in 12 months. Better Eurozone economic data is needed for EURCHF to rise, in our view.
  • The ECB shifted its focus from politics to domestic data releases at its latest meeting, by making the tapering of its bond-buying program and its rate-hike decision heavily data dependent.
  • The Swiss National Bank is maintaining its adaptive policy stance, even though the Swiss franc is no longer strongly overvalued.

USDCHF

  • We maintain our USDCHF forecast at 0.98 in three, 0.96 in six and at 0.94 in 12 months. USDCHF is likely to remain in the 0.95-1.00 range that prevailed for most of last year.
  • Rising risks around trade policy, Italian politics and the stability of global growth led to risk aversion. This typically sees safe haven currencies – USD and the CHF – appreciate.
  • We expect the Swiss franc to gain relative to the USD in the long term due to the strength of Switzerland's public finances and relatively low inflation and an improving environment for the euro.

Fixed Income & Monetary Policy

  • The global economy is likely to remain robust in the next twelve months, although the risks have risen appreciably. Despite this uncertainty, we expect further interest rate hikes by the US Federal Reserve (Fed) this year. The ECB, by contrast, has become more cautious in its outlook.
  • In an environment characterized by uncertainty, the SNB is unlikely to increase interest rates for the first time after the ECB makes its first move next September. Positive prime rates are not expected in Switzerland before 2020.
  • Any merely cautious normalization of monetary policy in industrial nations results only in a slight rise in ten-year bond yields – in the US, it even just results in a range trading trend.

Real Estate

  • The Swiss National Bank has observed an increase in risks in the residential property market and is therefore calling for regulatory measures to be tightened.
  • Apartment building yields in top locations have advanced in parallel with interest rates. However, in view of distorted interest rates, this does not permit any clear verdict on prices.
  • Valuations in peripheral locations are in part excessive in view of the greatly increased risk of vacancies.
  • Tightening of regulatory measures would distort the market in favor of pension funds and appears inopportune in view of the advanced stage of the cycle.

Sectors

  • The Swiss economy is continuing to recover from the franc shock.
  • Industry in particular is seeing a clear uptrend, whereas for service companies the dynamism is waning somewhat.
  • But not all sectors can benefit equally from the favorable starting position.

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